The rapid expansion of the exchange-traded fund (
ETF
) marketplace has spurred innovation along with conflicting
philosophies about the best way to assemble and manage stock and
bond market indexes.
Even though traditional indexes, which weight stocks and bonds
according to the size of their market capitalization, still
dominate the investment landscape, both fundamental and
equal-weight index strategies have emerged.
Let's briefly review each.
Traditional Index Investing
The basic tenet of classic or traditional indexing is to
eliminate the risk of market underperformance by closely tracking
stock and bond indexes with the lowest possible costs. Stocks with
the largest market size within a market cap weighted index will
typically have the greatest impact on performance and volatility
whereas mid and small cap companies have less influence.
Many widely followed indexes such as the DJ Wilshire 5000,
Russell 2000, and S&P 500 follow a market cap weighted
formula.
The iShares, State Street Global's SPDRs, and Vanguard's ETFs
tend to favor this classic weighting methodology.
Potential Advantages:
Low portfolio turnover of index components Market determines
weighting of each component
Potential Disadvantages:
Could under perform alternative weighted indexing strategies
Under-represents stocks with smaller market capitalizations
Fundamental Index Investing
Fundamental indexes attempt to outperform classic benchmarks by
screening securities based upon various financial measures. Some of
these metrics include sales, book value, cash flow, valuation and
even dividends. Many of these indexes tend to have a value bias or
tilt, which probably explains their strong performance when value
stocks are in favor.
One of the most prominent fundamental indexes is the FTSE RAFI
U.S.1000. It passively selects the largest U.S. stocks based upon a
company's fundamental measures: book value, income, sales and
dividends. After the stocks have been selected, companies with the
highest fundamental strength are weighted by their fundamental
scores. The fundamentally weighted portfolio is rebalanced and
reconstituted annually. Other index versions of the FTSE RAFI
methodology follow specific industry sectors, midcap stocks and
international equities.
Many ETFs issued by Claymore, First Trust, PowerShares, and
WisdomTree Investments follow a fundamental indexing strategy.
Potential Advantages:
Reduces exposure to stocks with the highest market capitalization
Alternative satellite position to pure active management
Potential Disadvantages:
Could underperform traditional market cap weighted indexes when
value or dividend bias in the index construction is out of favor
Higher investment costs
Equal Weighted Index Investing
Equal weighted indexes offer an interesting alternative for
investors not entirely convinced by either traditional or
fundamental indexing. In an equal weighted index, securities are
assigned the same weighting or representation, regardless of their
market size, financial metrics or other factors.
For example, the S&P Equal Weight index has the same
holdings as the cap weighted S&P 500, but each company is
assigned a fixed weight of 0.2% and rebalanced quarterly. This
indexing strategy prevents stocks with the largest market size from
dominating the index.
Equity equal weighted indexes tend to outperform when mid and
small cap stocks are in favor. In contrast, they are most likely to
underperform when large company stocks are strong gainers.
Another consideration is transaction costs. Since equal weight
indexes tend to rebalance more frequently than market cap indexes,
trading costs can add up.
Rydex Investments offers a series of ETFs with an equal weight
index strategy.
Potential Advantages:
Reduces exposure to stocks with the highest market capitalization
Alternative satellite position to pure active management
Potential Disadvantages
Could underperform when large stocks are in favor Higher investment
cost
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